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By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 1, No. 23 on November 27, 1992. 

The article that appears on our front page is generally meant to be informative and/or instructional. It often ties in with current market conditions, which means the topics are quite specific. We do, however, have a broader array of topics that we insert when market conditions warrant. This is one of those times. We will discuss the use of LEAPS (long-term options) as a substitute for stock ownership. Many brokerage firms and investment publications are proponents of this strategy. However, as you will see, it sometimes is over-rated.

Stock owners probably could substitute a long in-the-money call for their long stock. This is not a new idea; it has always been available as a strategy using short-term options. However, its attractiveness seems to have increased with the introduction of LEAPS. Frequently people are examining the potential of selling the stock they own and buying long-term calls (LEAPS) as a substitute, or buying LEAPS instead of making an initial purchase in a particular common stock.

Substitution For Stock Currently Held Long

Simplistically, the strategy involves this line of thinking: if a stock owner sells his stock, he could reinvest a small portion of the proceeds in a call option -- by that providing continued upside profit potential if the stock rises in price -- and invest the rest in a bank to earn interest. The interest earned would act as a substitute for the dividend, if any, to which he no longer is entitled. Moreover, he has less downside risk: if the stock should fall dramatically, his loss is limited to the initial cost of the call.

In actual practice, one should carefully calculate what he is getting and what he is giving up. The costs to the stock owner who decides to switch into call options as a substitute are commissions, the time value premium of the call, and the loss of dividends. The benefits are the interest that can be earned from freeing up a substantial portion of his funds, plus the fact that there is less downside risk in owning the call than in owning the stock.

Example: XYZ is selling at 50. There are one-year LEAPS with a striking price of 40 that sell for $12. XYZ pays an annual dividend of $0.50 and short-term interest rates are 5%. What are the economics that an owner of 100 XYZ common stock must calculate in order to see if it is viable to sell his stock and buy the one-year LEAPS as a substitute?

The call has time value premium of two points (40 + 12 - 50). Moreover, if the stock is sold and the LEAPS purchased, a credit of $3800 less commissions would be generated. First calculate the net credit generated:

                       Sale of 100 XYZ stock   $5000 
Cost of one LEAPS call     $1200
Less stock commission                           - 25
Plus option commission       15
Net sale proceeds:                             $4975 credit
Net cost of call:          $1215 debit

Thus one would take in a total credit balance of $3760 if he sold his 100 XYZ and bought the call instead. Now the costs and benefits of making the switch can be computed:

Costs of switching:           Fixed Benefit from switching:
    Time value premium  -$200  Interest earned on
    Loss of dividend           -$ 50              credit balance of $3760
    Stock commissions   -$ 25  at 5% interest for one year=
    Option commissions         -$ 15              0.05 x $3760: +$188
    Total cost:                -$290

Finally, the stock owner must now decide if it is worth just over 1 dollar per share in order to have his downside risk limited to a price of 39½ over the next year. If the investor decides to make the substitution, he should invest the proceeds from the sale in a one-year CD or T-Bill for two reasons. First, he locks in the current rate -- the one used in his calculations -- for the year. Second, he is not tempted to use the money for something else, an action that might negate the potential benefits.


This $102 seems like a reasonably small price to pay to make the switch from common stock to call ownership. However, when the year is up, he will have to pay another stock commission to repurchase his XYZ common if he still wants to own it (or he will have to pay two option commissions to roll his long call out to a later expiration date). One other detriment that might exist is that the underlying common might declare an increased dividend or, even worse, a special cash dividend. The LEAPS call owner would not be entitled to that dividend increase -- in whatever form -- while, obviously, the common stock owner would have been. If the company declared a stock dividend, it would have no effect on this strategy since the call owner is entitled to a stock dividend. A change in interest rates is neither a positive nor negative factor since the owner of the LEAPS should invest in a one-year Treasury Bill or a one-year CD and therefore would not be subject to interim changes in short-term interest rates. There may other mitigating circumstances, involving tax considerations. If the stock is currently a profitable investment, the sale would generate a capital gain, and taxes might be owed. If the stock is currently being held at a loss, the purchase of the call would constitute a wash sale and the loss could not be taken at this time.

Arbitrage Possibility: In theory, the calculations above could produce an overall credit: the interest earned from putting the proceeds in the bank for one year could be larger than the cost of switching as calculated. In such a case the stock holder would normally want to substitute with the call unless he has overriding tax considerations, or suspects that a cash dividend increase is going to be announced. Be very careful about switching if this situation should arise. Normally, arbitrageurs -- persons trading for exchange members and paying no commissions -- would take advantage of such a situation before the general public could. If they are letting the opportunity pass by, there must be a reason (probably the cash dividend), so be extremely certain of your economics and research before venturing into such a situation.

In summary, holders of common stock on which there exist in-the-money LEAPS should evaluate the economics of substituting the LEAPS call for the common stock. Even if arithmetic calculations call for the substitution, the stock holder should consider his tax situation as well as his outlook for the cash dividends to be paid by the common before making the switch.

Buying LEAPS As The Initial Purchase Instead of Buying Common Stock

Logic similar to that used above can be used to determine whether a prospective purchaser of common stock might want to buy a LEAPS call instead of the actual common. In other words, such an investor does not already own the common. He is going to buy it. This prospective purchaser might want to buy a LEAPS call and put the rest of the money he had planned to use in the bank instead of actually buying the stock itself. He can calculate his fixed costs (which now consist only of time premium and loss of dividend) and compare them to the amount of money he has available to put in the bank, since he'd spend less for the LEAPS call than he would have for the common stock. He could even make a comparison of buying the LEAPS versus buying the stock on margin if he wanted, in which case he would save the margin interest costs, but would have less money left over to put in the bank for one year. It is generally more likely that the cost versus benefit comparison will favor the LEAPS purchase for the initial purchases of common stock, especially if he is considering using

Protecting Existing Stock Holdings With LEAPS Puts

What was accomplished in the substitution strategy discussed above? The stock owner paid some cost ($102 in the example) in order to limit the risk of his stock ownership to a price of 39½. What if he had just bought a LEAPS put instead? Forgetting the price of the put for a moment, concentrate on what the strategy would accomplish. He would be protected from a large loss on the downside since he owns the put, and he could participate in upside appreciation since he still owns the stock. Isn't this what the substitution strategy was trying to accomplish? Yes, it is. Moreover, when buying the put, only one commission is paid -- that being on a fairly cheap out-of-the-money LEAPS put -- and there is no risk of losing out on dividend increases or special dividends.

The comparison between substituting a call or buying a put is a relatively simple one. First do the calculations as they were performed in the initial example above. That example showed that the stock holder's cost would be $102 to substitute the LEAPS call for the stock, and such a substitution would protect him at a price of 39½. In effect, he is paying $152 for a LEAPS put with a strike of 40 -- the $102 cost plus the difference between 40 and the 39½ protection price. Now, if an XYZ one-year LEAPS put with strike 40 were available at 1-1/2, he could accomplish everything he had initially wanted, by merely buying the put. Moreover, when one year has passed, he would spend less in commissions to keep the protection in place. The purchase of a put may suspend his holding period for tax purposes (if he is not already a long-term holder), but the LEAPS call strategy had its own tax complications as well. The fact that he would save commissions and still be in a position to participate in increased cash dividends should make the put worth even more to the stock holder, so that he might pay even slightly more than 1½ for the put. If the LEAPS put were available at this price, it would clearly be the better choice and should be bought instead of substituting the LEAPS call for the common stock.

Thus, any stock holder who is thinking of protecting his position can do it in one of two ways: 1) sell the stock and substitute a call, or 2) continue to hold the stock and buy a put to protect it. LEAPS calls and puts are amenable to this strategy. Because of the LEAPS long-term nature, one does not have to keep reestablishing his position and pay numerous commissions as he would with short-term options. The stock holder should perform the simple calculations as shown above in order to decide if the move is feasible at all, and, if it is, whether to use the call substitution strategy or the put protection strategy.


This article was originally published in The Option Strategist Newsletter Volume 1, No. 23 on November 27, 1992.  

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